Should US Investors Be Worried That a Stock or Bond Bubble Is Forming?

Market watchers are legitimately concerned that it is the Fed propping up markets and not fundamentals.

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Paul Krugman dismisses the notion that a stock or bond bubble is forming. He attributes anxiety over heady stock or bond prices to "wishful thinking" and a "deep hatred of Ben Bernanke." Really? Investor cautiousness is purely personal? Doubtful.

Market watchers are legitimately concerned that it is the Fed propping up markets and not fundamentals; more importantly, they are exercising the kind of vigilance we should have maintained during the housing boom or the dot-com craziness. With Dr. Bernanke continuing to administer $85 billion per month of liquidity to a sickly economy, we should indeed be en garde.

The stock market continues to hit new highs, and is up some 15% so far this year, but few are enjoying the ride. The disconnect between lackluster growth and an all-time record Dow Jones (INDEXDJX:.DJI) has investors looking over their shoulders. It is not just stock prices that Mr. Bernanke has inflated. Yields on junk bonds in the US – those with low credit ratings – fell below 5% for the first time; that compares to a record high of above 20% at the height of the financial crisis in December 2008.

Cheap money is fueling the kind of hyped-up buyout activity that puts some on alert and prompted Apollo Global Management's Leon Black to recently comment, "There's no institutional memory, we know that about Wall Street." There are also signs of a rebirth in collateralized debt obligations (banks issued $26 billion of CLOs in the first quarter – more than in the same 2007 period according to the New York Times) and other structured securities of the sort that undermined credit markets in the downturn. The Fed recently issued a warning: "Prudent underwriting practices have deteriorated."

Meanwhile, the economy sputters along, unable to gain momentum. There are indeed bright spots – especially housing, where higher prices are beginning to lift the overhang from underwater mortgages. Foreclosure filings in April sank to a six-year low, and are down 23% from last year – definitely good news. Also, after sinking under the Sequester scare, consumer confidence rallied last month – essential for spending.

Perhaps most important, the jobs numbers appear to be improving. Without a doubt this economy cannot get rolling without a more robust recovery in employment and income. On the other hand, an uptick in hiring suggests that one of the biggest props to earnings (and to markets) may vanish – namely the margin improvements that companies racked up coming out of the recession. As the financial crisis hit, managements across the board hunkered down, laying off excess workers and streamlining operations. Even as demand began to rebound, most companies found they could do more with less. Productivity soared, leading to substantial earnings gains. That game may be over.

According to research titans ISI Group, we are three-quarters of the way through the first quarter earnings season, and nearly 70% of reporting companies have beaten expectations – a good sign. The norm, ISI says, is about 66%. (In other words, earnings reports are something of a rigged game.) At the same time, managements have not painted such a rosy picture for the balance of the year. FactSet Research reports that 63 companies have issued negative earnings guidance going forward, with only 17 upping their forecast. The caution reflects that while earnings are growing at a little more than 3% on average, revenues have not kept pace. Over half of the 400-odd companies that have reported first-quarter results had disappointing revenues. Demand has simply not accelerated.

At 14 times forward earnings, stock prices are not high by historical standards, especially given today's bond yields or inflation rate. It is, of course, the latter yardstick that is most closely watched by investors. The Fed has a dual mandate: lifting employment and suppressing inflation. If price increases, which have been muted by overcapacity on all fronts, start to rise, it is presumed Mr. Bernanke will begin to rein in the bond-buying program.

Meanwhile, investors find comfort in this: There is no place else to go. By comparison with the sluggish EU, or the uncertain outlook for a number of developing countries (China and Brazil, especially), the US looks like a good bet. Proof of our comparative appeal can be seen in the relative strength of the dollar.

Though the dollar has weakened recently compared to the yen, it has not been pummeled by the Fed's unprecedented intervention. Jumping into a stock market hitting record highs because it's the only game in town is not appealing – but that may be better justification than Krugman's advisory that "there isn't any case for believing that we face any broad bubble problem."

For the time being, the best advice may remain: Don't fight the Fed. But, notwithstanding Mr. Krugman's advisory, stay vigilant.